WHITE PAPER ‘ESG’ INVESTING: WHAT IS IT, WHERE ARE WE NOW, WHERE IS IT GOING? ‘ESG’ INVESTING: WHAT IS IT, WHERE ARE WE NOW, WHERE IS IT GOING?
Whilst there would be little in the way of debate that can be brought about by the basic as to whether ‘COVID-19’ was the most frequently mismanagement of environmental issues. occurring term in 2020 within the world of asset management – or indeed in any context – few A new element – investing responsibly – is now would be likely to disagree that ‘ESG’ would have in the ascendancy therefore, and is assuming run it a very close second. Indeed, given the considerable importance. The broader history meteoric rise in the popularity of ESG-focused of responsible investing can be traced back to investing over recent years, it’s remarkable to the 18th century, when religious groups such as reflect on the fact that, as little as a dozen or Quakers and Methodists placed restrictions on so years ago, it was a concept that was rarely the types of company in which their followers contemplated, let alone adopted … and, in some could invest. The practice did not emerge in quarters, actively eschewed. any substantive form until the 1960s however, and was then typically referred to as socially This acceleration in interest regarding all things responsible investing (SRI), although other ESG is almost entirely attributable to deepening terminology was also in use: social, socially public interest in matters of societal importance: conscious, sustainable, green or ethical investing climate change, sustainability, the environment amongst others. At the time, the approach was and conservation, for example. One need only relatively simplistic and involved little more turn on the TV, pick up a newspaper or immerse than excluding sectors such tobacco, oil and oneself in a selection of social media platforms gas, and arms from one’s portfolio. Friends for confirmation. Whether it’s Swedish teenage Provident’s Stewardship Fund – the first major One cannot fail to observe that the environmental activist Greta Thunberg exhorting ethical fund in the UK marketplace, and the her fellow schoolchildren to take part in strikes initiative which led the way in terms of focused tide of sentiment is turning, attitudes to promote climate action, Extinction Rebellion ethical investment in many people’s eyes – has protestors bringing London’s traffic to a halt, been around since 1984. A lot has happened are changing, and organisations of or the relentless efforts of those such as Sir in 35 years however, with the space becoming all kinds are responding. David Attenborough in TV programmes such as increasingly populated and increasingly complex ‘Climate change – the facts’ to alert us to the – for asset managers, advisers, corporations implications of human behaviour on the natural and consumers alike. world, one cannot fail to observe that the tide of sentiment is turning, attitudes are changing, Turning to ESG itself – the current in vogue idiom and organisations of all kinds – asset managers – the term was originally coined in 2006 with included – are responding. Whilst the COVID-19 the launch of the UN Principles for Responsible pandemic may have, albeit temporarily, eclipsed Investment (PRI), whose foundations had been the entreaties of Thunberg, Attenborough and laid over the prior two years. Signatories of the others, it’s nevertheless underlined all too clearly PRI, of which one can now count most major the grave and far-reaching economic damage professional asset management firms, are
2 3 bound to follow six principles which demand the incorporation, disclosure and promotion of Another contributory factor to these enhanced fund flows was the ongoing expansion in the number of ESG issues. However, the term didn’t meaningfully enter the vernacular until the arrival of the ESG products available to investors – a far cry from the peripheral territory they once inhabited. 105 new UN Sustainable Development Goals in 2015 and, as such, catalysed a paradigm shift: ESG funds launched in Q3 of 2020, bringing the year-to-date total to a new record of 333. This compares 1 establishing the first voluntary link between sustainability and financial services, and preceding with 265 over the same period last year. other notable landmarks such as the signing of the UN Paris Agreement in 2016 and the European Commission’s Action Plan on Financing Sustainable Growth in 2018.
INVESTMENT FLOWS – THE DIRECTION OF TRAVEL Quarterly European Sustainable Fund Launches
In early April 2019, the Global Sustainable Investment Alliance (GSIA) released the fourth edition Active Passive 140 of its biennial Global Sustainable Investment Review 2018, showing that:
120 • global sustainable investment assets under management reached over $30 trillion at the start of 2018, a 34% increase from 2016 100 • responsible investment commands a sizeable share of professionally managed assets regionally, 80 ranging from 18% in Japan to 63% in Australia and New Zealand • Europe accounts for the largest pool of sustainable investment assets with €12.3 trillion ($14.1 60 trillion), followed by the US with $12.0 trillion. 40 The next edition of the GSIA’s authoritative biennial review is eagerly anticipated in April 2021 and few industry commentators are predicting anything other than a continued advance in both the 20 volume and share of global assets being managed on a sustainable basis. A significant milestone was reached at the end of Q3 of last year, when the level of assets in European sustainable funds 0 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 breached the $1 trillion threshold for the first time, a 10% increase over the previous quarter. This 2015 2016 2017 2018 2019 2020 compares with just a 1.6% increase in assets for the overall European fund universe.1 Source: Morningstar Direct, Morningstar Research, Data as of September 2020
Quarterly European Sustainable Fund Assets (EUR)
Active Passive Furthermore, a recent study by PwC predicts that by 2025, in Europe alone, ESG funds could represent a 1000 higher value of assets under management than their non-ESG counterparts, with the former accounting for 900 57% of the market – a staggering 28.8% compound annual growth rate from 2019 to 2025, and repre- Billions 800 senting a revolutionary, all-encompassing shift in the investment landscape of proportions hitherto unseen 2 700 in the European fund industry.
600 Clearly, sustainable investing now constitutes a major force across global financial markets … but in an 500 era where ESG investing has morphed from pipe-dream to mainstream, what exactly is it? 400
300
200
100
0 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 2016 2017 2018 2019 2020
Source: Morningstar Direct, Morningstar Research, Data as of September 2020 1 Source: Morningstar, as at 30.09.20 2 Source: PricewaterhouseCoopers, 2022 – The growth opportunity of the century, November 2020
4 5 ‘ESG’ – WHAT IS IT? than the well-publicised travails of businesses such as Enron, or more recently Carillion, Businesses can encounter Historically, the majority of asset management to grasp how toxic philosophies such as an teams, and indeed private investors, would obsession with short-term profits or a delusional serious problems if have pursued the shareholder value theory: optimism regarding profitability, can rapidly also known as the ‘Friedman Doctrine’, it was pervade a business’s culture, leading to flawed management teams are popularised in 1970 by Milton Friedman who – and, in some cases, illegal – decision-making advanced the notion that a business’s only which, in turn, serves only to accelerate its concerned solely with the social responsibility is the maximisation of demise. In April 2010, the explosion and sinking fulfilment of profit targets. shareholder value. Proponents of the doctrine of the BP-operated Macondo Prospect led to placed the pursuit of profit ahead of all other the Deepwater Horizon disaster, the largest considerations, and certainly above the pursuit marine oil spill in US history. BP bore the brunt of principles. SRI emerged in the 1960s and of the blame, with pervasive cost-cutting cited ‘70s, around the same time as Friedman’s as the key contributory factor. Of the 17 S&P philosophy: whilst some view the Quakers’ 500 companies that went bankrupt between earlier exclusion of ‘sinful’ companies as the 2005 and 2015, 15 had scored poorly on ESG most significant derivation of this philosophy, five years previously. others point to South Africa’s apartheid era as the pivotal moment, when investors began Given that many of the largest corporate losses divesting from companies that did business have been precipitated by governance failings there, based on both moral and ethical grounds. and fraudulent behaviour, risk management has become a common motivation for ESG. The genesis of the movement was built on a When the movement first emerged, it was deepening collective recognition that, whilst primarily driven by a tiny minority of investors an absence of profits can bring obvious who wanted to promote positive social and difficulties of its own, businesses can encounter environmental change – Swedish pension funds serious problems if management teams are were a case in point. What’s really driving the concerned solely with the fulfilment of profit sector’s growth now is a substantial group of targets in order to appease shareholders, executives and financiers who want to avoid at the expense of all other stakeholders: harm, whether to their own reputations or to employees, customers, suppliers, distributors, the wider world. Scrutiny of companies is now the community et al. One need look no further at a level where decision-makers feel that it is more imprudent to ignore ESG issues than to embrace them. ESG is now no longer simply a campaigning cause; it has become a risk Of the 17 S&P 500 management tool. As ESG considerations move beyond a specialised niche into the companies that mainstream, and investors – both institutions went bankrupt and individuals – increasingly seek to conflate a social conscience with the quest for superior between 2005 and returns, concerns about the risks they are absorbing in order to achieve those returns 2015, 15 had scored become paramount. In addition to being poorly on ESG five appropriate to their objectives and attitudes to risk, there is now a need for asset selections years previously. to align with the investor’s ethics, values and moral compass.
6 7 ESG investing is any investment strategy which seeks to consider both financial return DRIVERS OF GROWTH measures required to spark global economic recovery. Unsurprisingly, the EU’s 27 heads and environmental Three key catalysts have surfaced in recent of state have declared that ‘the green good to bring about years in fuelling the ever-widening popularity of transition’ is central to their post-COVID-19 ESG investing. These are: recovery plan. societal change. • Investor demand – The societal shifts • Regulatory pressure – We have seen described above have given rise to a new a major shift from voluntary measures to cohort of investors motivated as much, if binding legislation, which is likely to have not more so, by non-financial impacts as by a profound impact on driving the transition financial returns. Of these, institutional inves- to a more sustainable model of investing. tors form the largest component, not least Governments, needless to say, have been as they are compelled to react to mounting enthusiastic in their embrace of ESG. In the pressure from policymakers and their wider UK for example, one of Theresa May’s final universe of stakeholders to incorporate acts before stepping down as prime minister sustainability more intrinsically into their in 2019 was to enshrine in law a commitment mandates. In response, asset managers are to reach net zero carbon emissions by – as we’ve seen – increasingly incorporating 2050, making it the first member of the G7 ESG standards into their offerings: either group of industrialised nations to do so. developing new vehicles with sustainable In November, Boris Johnson announced mandates or repurposing existing vehicles. his ‘Ten Point Plan’ to kickstart a green industrial revolution, which will see £12bn of government investment into the net zero target. France also proposed net zero … AND HOW DOES IT WORK? emissions legislation last year, while some smaller countries have targeted dates prior An attempt at an all-encompassing definition to 2050, such as Finland (2035) and Norway of ESG investing might broadly resemble the (2030), although the latter allows the buying following: “ESG investing is any investment of carbon offsets. Demark has very recently strategy which seeks to consider both financial become the first major oil producer to stop return and environmental good to bring about offering oil and gas exploration licences, societal change that’s regarded as positive by ending production by 2050. proponents. It therefore aims to exclude profiting from activities that are considered harmful to • Societal shifts – The public’s awareness society and the environment, and to invest in of climate change issues has propelled organisations, companies and projects that sustainability to the forefront of the global are committed to operating in a way that is agenda, with society attributing increased sustainable – and positive – for the future.” levels of importance to sustainable finance and ESG. Interestingly, COVID has accelerated Whilst the approach is relatively easy to this shift, bringing the real-world implications describe in the abstract, it is harder to do so of neglecting ESG factors sharply into focus, definitively and, therefore, difficult to implement and prompting a particularly strong response authoritatively. At its simplest, it involves the use from policymakers on the important role of exclusionary screens, or filters, that investors that ESG could – and should – play in the
8 9 can deploy to eliminate ESG transgressors from the traditional investment universe, ie businesses In the food and drink deriving some or all of their earnings from one or more of the traditional ‘sin’ industries – animal sector, concerns over testing, fur, gambling, pornography, tobacco or the health effects weapons – or those which have a particularly poor record in terms of human rights or corruption. of excessive sugar This is commonly referred to as ‘negative consumption are screening’. The alternative approach – ‘positive screening’ – seeks to invest in companies which resulting in shifting are actively making a positive contribution to a range of ESG themes, such as improvements consumer preferences. in energy efficiency, affordable healthcare or micro-finance (and other forms of financial inclusion). However, one should note the nuclear power, food and drink or technology distinction between an ethical, responsible or is more debatable. For example, BP is going impact-driven investment process, and an ahead next year with a shareholder resolution ESG integrated process. Specific ethical, in support of its goal of net zero emissions by responsible or impact-driven processes will 2050, a goal previously declared by Shell which often define the objective of an investment is also diversifying its product line-up by enter- vehicle such that the investment process is built ing the electric vehicle market. In the food and entirely around the philosophical belief of the drink sector, concerns over the health effects of client or manager. ESG investing, on the other excessive sugar consumption are resulting in hand, is far more flexible, and represents the shifting consumer preferences, regulation and integration of material ESG risk factors into an litigation, with soft drink companies trying to ad- enduring investment process. dress the risk through reduced-calorie products and marketing restrictions. The industry is also Returning to the subject of negative screening, under increased scrutiny for using its influence the logic for the exclusion of businesses indulging to mislead the public about sugar-related health in activities such as alcohol, fossil fuels, risks, although Danone and Nestlé lead the way in terms of sound corporate behaviour because of their disclosure of relatively robust product health, marketing and political involvement ESG investing is policy commitments.
far more flexible Moving on to technology, it is a sector which and represents the naturally screens well for ESG in that its constituents tend to have a small carbon integration of material footprint as well as younger and more diverse ESG risk factors into workforces. However, firms like Alphabet (which owns Google and YouTube), Facebook (which an enduring owns Instagram and WhatsApp) and Microsoft investment process. have consolidated market power to the point that anti-competitive concerns have emerged, raising the possibility that these tech giants
10 11 Tax Su pp Transparency ly C Biodiversity h a Risk in Management : Climate E Change n v i r could face anti-trust litigation and eventually be broken up. Moreover, the collection of massive En o e v n c ir n o m amounts of consumer data, which are then leveraged for advertising and sales revenue, not only Corporate a n n m Pollution & e creates significant competitive advantages but also raises issues surrounding privacy and concern Governance r n
e e Resources t
a v n
over the spread of disinformation. Regulators, particularly the European Commission, are l
o ESG t
a G
beginning to question whether the concentration of power in technology companies is beneficial RATINGS l for consumers over the long run. More positively, while Alphabet became embroiled in an Water Anti- Security anti-trust law suit in October of last year, it did become carbon neutral in 2007 and became the Corruption first company of its size to use renewable energy to counteract its entire output. Social Labour Customer The issues are far from binary therefore – not least as there are no absolutes as to what constitutes Standards Responsibility
morality – and, as a result, ESG investment remains somewhat subjective in nature. Given the lack Human Health & of any consensus as to what constitutes ‘good’ corporate behaviour consistent with ESG principles, Rights & Safety Community available definitions are invariably based on value judgements, and there exists no standard reporting framework. Moreover, asset managers are obliged to rely heavily on ESG ratings Su ial providers – the likes of MSCI, FTSE Russell and Sustainalytics are amongst the most prominent – pply Chain: Soc in the process of stock selection, whose proprietary scoring methods often yield radically different assessments of the same business. Source: FTSE Russell
Interestingly – or perhaps worryingly – a study published by Research Affiliates, a US-based global leader in asset allocation, in January last year compared the performance of two portfolios, one in DOES A FOCUS ON ESG LEAD TO OUTPERFORMANCE? Europe and one in the US, each constructed based on the ratings of two well-known ESG ratings providers. The portfolios yielded large performance dispersion and low correlation of returns: over There is now a substantial body of empirical analysis dispelling the long-held view that, by investing the eight-year period for which ratings data was available from both providers – July 2010 to sustainably, investors are foregoing the potential for outperformance; indeed, there is burgeoning June 2018 – the European portfolios had a performance dispersion of 70 basis points a year evidence that suggests a strong synergy between the two, supporting the view that a company’s focus (9.4% versus 8.7%) and 130 bps a year in the US (14.2% versus 12.9%), which translates into on sustainability is fundamentally indicative of its board and management quality. a cumulative performance difference of 10.0% and 24.1% respectively over the full period!3 This represents a noticeable difference for two strategies with an identical portfolio construction process. By way of example, ESG-focused assets significantly outperformed the market in the wake of the COVID-19 crisis: of the more than 2,800 ESG-themed funds tracked globally by Bloomberg, the average The study also examined 20 of the largest US corporations by market capitalisation in terms of their year-to-date decline by 13th March 2020 – approximately the mid-point of the sell-off – was 12.2%, less overall ESG rating and individual environmental, social and governance ratings from the two ratings than half the decline of the S&P 500.4 providers, and found an abundance of anomalies. For example, ratings provider 1 ranked Wells Fargo in the top third by governance in their universe, whereas provider 2 ranked it in the bottom This outperformance has continued throughout 2020: data from FE Analytics confirms that the MSCI 5%. This data was collected in 2017 when Wells Fargo was in the middle of its very public fake ACWI ESG Universal Index (made up of global stocks that have a ‘robust’ EGS profile and a positive account scandal. Similarly, provider 1 scored Facebook in the top quartile on environmental criteria trend in improving that profile), made a total return of 5.31% between the start of 2020 and the end 3 whilst provider 2 scored it in the bottom quartile. MSCI ranks Tesla at the top of the automotive of August, whilst the broader MSCI AC World index was up just 3.64%. Furthermore, of the 27 ESG table; FTSE Russell regards it as the worst carmaker globally based on ESG criteria. Investment Association sectors analysed (certain sectors were excluded as they are not home to
3 Source: Research Affiliates, LLC, What a difference an ESG ratings provider makes!, January 2020 4 Source: Bloomberg, as at 13.03.20
12 13 any ESG strategies), ESG funds outperformed their non-ESG counterparts across 21 (see table available 10 years ago still exist, compared with ESG criteria are increasingly being deployed below). Looking specifically at IA Global – this peer group is home to the most ESG strategies – the 46% for traditional funds, an indication of the as risk management metrics, and that strong average ESG fund delivered a 10.1% total return whilst the conventional peers averaged a total return former’s enduring appeal.6 performers are likely to see a marked reduction of just 4.09%.5 in their cost of capital – a competitive advantage Henderson EuroTrust, a Europe (ex-UK) which would naturally lead to an increase in investment trust focusing on high quality, mid equity value – he views European companies PERFORMANCE OF ESG AND NON-ESG FUNDS OVER 2020 to large cap equities, has consistently ranked as likely to benefit disproportionately from the as one of the leading trusts on Morningstar’s current trend. Average return of Average return of Outperformance Sector sustainability rankings. Its portfolio manager, ESG funds non-ESG funds of ESG funds Jamie Ross, has been an enthusiastic advocate With Europe established as the sustainable IA North America 26.7% 8.7% 18.0% of ESG as an integrated stock selection capital of the world at present, and therefore IA Flexible Investment 7.0% -1.8% 8.8% methodology, his investment process being so leading the way on ESG issues, it’s perhaps IA Mixed Investment 40-85% Shares 5.3% -2.3% 7.6% focussed on governance and sustainability that unsurprising that Ollie Beckett – portfolio it naturally aligns with ESG. It’s an approach manager of TR European Growth, another IA UK Direct Property 2.4% -4.2% 6.6% which continues to bear fruit with the trust’s share investment trust within the Janus Henderson IA Volatility Managed 4.2% -2.3% 6.5% price and net asset value both well ahead of the stable albeit investing predominantly in small- to IA Global 10.1% 4.1% 6.0% benchmark over one, three, five and 10 years medium-sized European domiciled companies – 7 IA Global Equity Income 0.8% -5.1% 5.9% on a total return basis. Ross cites the fact that adopts a similar view. In common with Henderson the words and actions of the EU and member EuroTrust, performance has been impressive: the IA Mixed Investment 0-35% Shares 5.3% -0.3% 5.6% state governments – the formalisation in 2019 trust’s share price and net asset value are both IA Europe excluding UK 5.6% 0.0% 5.6% of Europe’s approach to sustainability via ahead of the benchmark over one, five and 10 IA Mixed Investment 20-60% Shares 1.6% -2.5% 4.1% ‘The European Green Deal’, followed by the years on a total return basis.7 IA Sterling High Yield 2.0% -1.8% 3.7% presentation of the 2030 Climate Target Plan in September of this year – have fed down to From an ESG perspective, Ollie regards the IA Targeted Absolute Return 2.8% -0.2% 3.0% individual European businesses as the key trust as well-placed, and sees significant IA UK Equity Income -18.1% -21.2% 3.0% phenomenon driving the focus regionally, to the potential at the small cap end of the market IA UK All Companies -14.5% -17.3% 2.9% extent that companies are now considerably which is well-populated with pureplay sustainable IA Property Other -9.7% -12.0% 2.3% more concerned about sustainability. This development goal businesses – in particular IA Global Emerging Markets 0.3% -1.2% 1.5% heightened interest manifests itself in a number those focused on energy transition – still available of ways, from the long-term incentivisation at very attractive valuation multiples. Amongst IA UK Smaller Companies -8.9% -10.3% 1.4% of management teams to radical shifts in those which are emblematic of ESG adoption IA Sterling Strategic Bond 3.0% 2.1% 0.9% business strategy. within the portfolio, he cites companies such IA Specialist -2.2% -2.8% 0.6% as Nordex, makers of wind turbines, Nexans, IA Short Term Money Market 0.3% 0.1% 0.1% Holdings within the trust playing to the manufacturers of the high voltage cabling that sustainability theme include plasma drug links wind turbines to the national grid, and SMA, IA Unclassified -1.1% -1.2% 0.1% maker Grifols, Dutch health nutrition provider which makes solar inverters. IA Global Bonds 3.4% 3.5% -0.1% DSM, Danish pharmaceutical specialist Novo IA Asia Pacific excluding Japan 4.9% 5.13% -0.4% Nordisk which has been at the cutting edge of IA Sterling Corporate Bond 2.9% 3.6% -0.7% diabetes care for almost 100 years and SIG TR European Growth Combibloc, the Swiss packaging company IA Japan -3.3% -1.2% -2.0% which, via its aseptic packaging, provides an … in common with IA Asia Pacific including Japan 7.2% 11.7% -4.6% environmentally friendly alternative to plastic. IA Europe including UK -7.6% -0.4% -7.1% According to Ross, it is no coincidence that seven of Henderson EuroTrust, the world’s 10 largest renewable energy companies performance has by installed capacity are European. Given that been impressive. Looking longer term, research from data provider Morningstar examining the long-term performance of a sample of 745 Europe-based sustainable funds shows that the majority of strategies have done better than non-ESG funds over one, three, five and 10 years. The study also showed that sustainable 5 Source: Source: FE Analytics, 31.12.19 to 31.08.20, data from FEfundinfo2020 6 funds have greater survivorship rates than non-ESG vehicles: on average, 77% of ESG funds that were Source: https://www.ft.com/content/733ee6ff-446e-4f8b-86b2-19ef42da3824 7 Source: Morningstar, to 30.11.20
14 15 WHAT NOW?
Investors are becoming increasingly aware of environmental, social and governance challenges around the world and the fundamental role that corporations can play in improving, or worsening, these issues… and genuine awareness is leading to genuine action. Moreover, investors also now have ample data to support the view that adopting an ESG approach does not necessarily mean resigning oneself to inferior performance, based on the largely undeniable logic that companies which demonstrate their awareness of, and adherence to, ESG principles are more likely to have superior standards of governance which, in turn, should translate into improved resilience in challenging economic conditions. As demand increases, so too will the range of investment solutions on offer.
The rise of ESG investing is set to continue.
In short, therefore, with sustainability issues now being prioritised at the highest governmental and corporate levels, the rise of ESG investing is set to continue; companies will undoubtedly be subjected to an increasing set of non-financial reporting requirements – such as disclosing their ESG impact – which will in all likelihood adversely affect the ability of poorer performers to raise capital.
Based on current trends, we anticipate that the use of ESG metrics will represent another key item in the toolkit used by asset managers to evaluate investments, alongside valuation ratios, earnings growth and balance sheet strength, among others. Portfolios which aren’t aimed at dedicated sustainable investors may also benefit from any ESG tailwinds therefore. As ESG investment processes become more sophisticated and the increasing impact and social acknowledgment of sustainability risks further shift investor sentiment in favour of ESG investments, it is hard to see how ESG considerations will not be incorporated into all of our investment decisions at some point in the future.
Last year, Charlie Munger – Warren Buffett’s long-time business partner at Berkshire Hathaway – expressed his opinion that all investing is value investing. It remains to be seen whether he will soon be advancing the view that all investing is ESG investing.
16 17 DISCLAIMER
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